Scientific Beta

While long/short multi-factor strategies will, by construction, harvest long-term factor premia, such strategies may expose investors to unintended risks, due to poor diversification, biases in terms of market exposure and pronounced cyclicality of factor premia. We document a long/short multi-factor strategy that addresses these challenges through risk management, factor diversification and top-down implementation.

While long/short multi-factor strategies will, by construction, harvest long-term factor premia, such strategies may expose investors to unintended risks, due to poor diversification, biases in terms of market exposure and pronounced cyclicality of factor premia. We document a long/short multi-factor strategy that addresses these challenges through risk management, factor diversification and top-down implementation. The portfolio construction process uses improved beta estimation techniques and well-diversified components to reduce idiosyncratic risk, which results in a long/short strategy with low volatility (2.14%), a high Sharpe ratio (1.10) and extremely low exposure to the market. Despite being constrained by a risk budget of roughly 8%, its low volatility enables it to use leverage of 3.5, which allows it to post total returns of 8.06%, net of shorting/borrowing costs and taxes. Purely systematic long/short strategies have the potential to be a transparent and cost effective alternative to actively managed long/short equity hedge funds.